What is a Qualified Small Business?
Section 1202 of the Internal Revenue Code outlines the criteria that create a capital gains tax exclusion for holders of qualified small business stock (QSBS). A critical component of the exclusion, which may be 50, 75, or 100 percent of the total gain excluded from capital gain tax, is determining whether the corporation issuing stock is, in fact, a qualified small business.
In 1202(d)(1), a qualified small business is defined as a domestic C corporation with aggregate gross assets of no more than $50,000,000 on or after the date of the Revenue Reconciliation Act of 1993, as well as immediately following the stock issuance.
“The term “qualified small business” means any domestic corporation which is a C corporation if—(A)the aggregate gross assets of such corporation (or any predecessor thereof) at all times on or after the date of the enactment of the Revenue Reconciliation Act of 1993 and before the issuance did not exceed $50,000,000…”
I.R.C. § 1202(d)(1)
A final criterion is that the corporation must submit required reports to the Secretary and to shareholders. The section does not provide additional detail on the content or timing of these reports, nor has the IRS promulgated any guidance relative to the reports. It does not appear as if the corporation needs to submit any information to the IRS.
What Happens if a Qualified Small Business does not Submit Required Reports?
Section 6652(k) of the Internal Revenue Code outlines the penalty if the qualified small business fails to submit required reports. The person who failed to submit must pay a penalty of $50 per report. In cases of negligence or intentional disregard, the penalty increases to $100 per report. If the report covers two or more years, the penalty is multiplied by the number of years. No penalty is applied if the submission failure is due to reasonable cause and not willful neglect.
The penalty is problematic because as noted, the IRS provides no guidance to qualified small businesses on the types of reports to submit and when to submit them.
How do these Criteria Affect Shareholders?
Shareholders who plan to claim the capital gains tax exclusion must compile and maintain support for the exclusion. Understanding the qualified small business criteria will help you collect appropriate documentation to support your exclusion. This becomes particularly important given the lack of detailed information from the IRS to help you determine whether a corporation is truly a qualified small business.
However, the IRS does use the Code of Federal Regulation § 1.199A-5 to interpret the definitions to expand on the broad language found under § 1202(e)(3). See more on our website at the Qualifying Industries section.
How does a Shareholder Obtain the Exclusion?
Shareholders report the sale of QSBS on Schedule D and IRS Form 8949 just like any other capital gain. The exclusion appears as a negative number on Form 8949.
However, individual tax filing instructions for Section 1202 are quite in depth. QSBS Expert has a detailed article which lays out the instructions and specific documentation needed to file for QSBS. See detailed IRS tax filing instruction for Section 1202 here.
How do I Support the Exclusion?
Some corporations offer written guidance to their shareholders based on information provided by the corporation’s tax professionals. In other cases, you may need to work with an accountant or tax professional to determine a specific corporation’s status. This is where QSBS Expert can help. Contact us for help with your specific QSBS situation.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.
